September 25, 2017

Freakonomics Loves Index Funds

A bazillion years after the rest of us knew that index funds were awesome, the popular podcast Freakonomics discovered the same thing.

I want to share a few highlights from their show. Let's begin with the active management versus index funds argument:

Many investors pay firms to manage their money — sometimes a percentage of assets, sometimes a flat fee. In return, you may get a variety of services — including advice about insurance or taxes. And, of course, investment advice: how best to save for a house, or your kids’ tuition, or retirement, whatever. Why pay someone for that advice? Because, let’s face it, investing can be confusing, and intimidating. All that terminology; all those options.

So you hire someone to navigate that for you — and they, in turn, use their expertise to pick the very best investments for your needs. This is called active management. They actively select, let’s say, the best mutual funds for your needs. And you pay them for their expertise. You also pay those mutual funds, by the way — sometimes there’s what called a sales load when you buy it; and an expense ratio, a recurring fee the fund deducts from your account. So, between the mutual fund fees and the investment fees, that’s usually at least a couple percent off the top — and that’s whether your funds go up or down, by the way. So hopefully they go up. Hopefully the active management you’re paying for is at least covering the costs?

What we actually found was the top 2 to 3 percent had enough skill to cover their costs. And the other 97 or 98 percent didn’t even have that.

This is why I like index funds -- they all but guarantee you're going to beat actively managed options. No one can consistently (if at all) pick the top 2-3% of actively managed funds. So the chances of doing better than simply investing index funds are almost zero.

Now let's compare the costs -- and how an average actively managed fund can cost you a ton of money:

We’ll start with the typical mutual fund.

They charge a lot for this service. We estimate the average expense ratio is almost 1 percent for an actively managed fund. Then these active funds, all of them have sales loads. The index funds do not. The active funds further turn over their portfolios at a very high rate and that’s costly. You add that all up and the cost of owning a mutual fund on average is 2 percent.

And how does that compare to an index fund?

You can buy an index fund of, an S&P 500 Index Fund, let’s say, for as little as 4 basis points, four one-hundredths of 1 percent. In a 7 percent market, you’re going to get 6.96 percent.That difference — 2 percent versus four one-hundredths of 1 percent — may not sound like a lot. But over time, those numbers are compounded by what Bogle calls the “relentless rules of arithmetic.”

If the market return is 7 percent and the active manager gives you 5 after that 2 percent cost, and the index fund gives you 6.96 after that four basis point cost — you don’t appreciate it much in a year — but over 50 years, believe it or not, a dollar invested at 7 percent grows to around $32 and a dollar invested at five percent grows to about $10. Think what an investor thinks about when he looks at that number. He says, “Wait a minute! I put up 100 percent of the capital. I took 100 percent of the risk and I got 33 percent of the return.” Well, anybody that thinks that’s a good deal, I’ve got a bridge I want to sell them.

Here’s the reality: this is the business, the mutual fund, actively-managed business, where you not only don’t get what you pay for, you get precisely what you do not pay for. Therefore, if you pay nothing, you get everything.

Add a few zeros to 32 and 10 and you can see what a huge difference this would make to a large amount of money like that found in a 401k. It's hundreds of thousands of dollars, if not millions, over the course of a working career.

This is the paradox of index fund investing -- that you can beat most others by being "average."

This is because index funds give you the average while actively managed funds give you their results LESS their high fees. The fees are the killer that usually takes the return rate below the average.

Finally, they talk about the difference between one index fund and another:

The Vanguard S&P 500 index fund is about 5 or 6 basis points. Schwab recently cut 1 to 2 or 3 basis points. There are S&P 500 funds with 50 and 75 and 100 basis points. It’s an insane — that is a tax on [the] dumb.

In other words, all index funds are not created equal. Why would you pay many times what you need to for the same thing?

You must be sure you invest in a LOW COST index fund, not just any index fund. Otherwise, you are just throwing money away.

Personally, I've used the same three index funds for the majority of my investing over the past 20 years.